Sidestep the ‘Sunk Cost Fallacy’ to Make Better Choices

The “sunk cost” thinking trap snares many unwary entrepreneurs: It springs shut the moment you devote additional resources to a project just because you’ve already invested some.

Simply put, a sunk cost is money, time, and/or energy that you’ve already expended and can’t get back. These costs are important and tricky, because when making decisions many small-business owners don’t treat sunk costs like they’re really gone.

For example, suppose you shell out $300 to send an employee to customer-service training. A week later, that same employee makes a major mistake and deserves immediate termination. If you think, “I just spent $300 on training her. By letting her go, I’m losing all that money,” then you’re falling prey to the sunk cost fallacy. The smarter course of action is to disregard your past spending and base your decision solely on current and projected future costs compared with potential returns.

Unfortunately, many small-business owners haven’t learned to recognize sunk costs and give them the short shrift they deserve. Instead, they succumb to a strong psychological drive to hang on to what they’ve paid for in the past without a financially sound reason.

Here’s how to avoid the sunk cost fallacy going forward:

1. Stop worrying about “looking foolish” or “maintaining consistency” in your spending. If you’ve invested time, money, or anything else in an item or project that now seems unlikely to pay off, cut your losses right away. Your ego may object, of course, but it’s sensible and mature to recognize that everyone (including you) makes mistakes. In fact, owning up to your errors can be helpful and productive. Make it a point of pride.

2. Before you spend on a project or item, calculate the likelihood of a good return, without considering how much you’ve previously invested there. Naturally, you want every investment to do well, but that’s unlikely to happen. So be realistic: Cut your losses (see #1) and move on to better opportunities. Bad investments rarely improve over time.

3. Understand that ongoing commitments to projects, objects, and patterns of spending should depend on their continuing usefulness. There’s a natural human tendency to feel an attachment to any choice we make or any course of action we pursue, especially when it has worked well for us before. But this tendency rarely pays off.One way to counteract this inclination is to weigh all your options on an equal footing. Another is to downplay your emotional attachment to the sunk-cost item and decide whether to continue to pursue it strictly on the basis of objective criteria. An interesting technique to use here is “zero-based thinking,” which reduces the influence of sunk costs.

Warning: None of these ideas should be used to justify flitting too often from one project to another or giving up on a worthwhile cause just because the going gets rough. Perseverance and commitment remain important to small-business success. But they should not become so ingrained that you allow the sunk cost fallacy to trap you in relatively useless efforts and investments.